Chapter20 forwardexchangecontracts2008

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  • 1. Gripping IFRS Forward exchange contracts Chapter 20 Forward Exchange ContractsReference: IAS 32, IAS 39 and IFRS 7Contents: Page 1. Definitions 622 2. Hedging: an introduction 622 2.1 Overview 622 2.2 What is a hedge? 622 2.3 What is a hedged item? 623 2.3.1 Forecast transactions (uncommitted) 623 2.3.2 Firm commitments 623 2.4 What is a hedging instrument? 624 2.5 How hedging is achieved using a forward exchange contract 624 Example 1: FEC to hedge an export transaction 625 2.6 How to discount a forward exchange contract 626 Example 2: present value of a FEC 626 3. Hedge accounting 627 3.1 Hedging requirements 627 3.2 Hedge effectiveness 628 3.3 Ineffective hedges 628 3.4 Cash flow hedges versus fair value hedges 628 3.5 Dates relevant to hedging 628 3.5.1 Post-transaction period 628 3.5.2 Pre-transaction period 629 3.5.3 Summary of periods and descriptions 629 3.6 Types of hedges 629 3.6.1 Overview 629 3.6.2 Fair value hedges 629 3.6.3 Cash flow hedges 630 3.6.4 Summary of the hedges over the periods 630 3.7 Accounting for hedges 631 3.8 FEC’s in the period post-transaction date 632 Example 3: FEC in the post-transaction period: fair value hedge 632 620 Chapter 20
  • 2. Gripping IFRS Forward exchange contracts Contents continued … Page 3.9 FEC’s in the period pre-transaction date 633 3.9.1 If there is no firm commitment 634 Example 4: FEC in the pre-transaction period (no firm 634 commitment): cash flow hedge (with a basis adjustment) Example 5: FEC in the pre-transaction period (no firm 636 commitment): cash flow hedge (with a reclassification adjustment) 3.9.2 If there is a firm commitment 637 Example 6: FEC in the pre-transaction period (with a firm 638 commitment): cash flow hedge up to transaction date Example 7: FEC in the pre-transaction period (with a firm 639 commitment): cash flow hedge up to firm commitment date and fair value hedge up to transaction date (and thereafter) Example 8: FEC taken out in the pre-transaction period with 641 a year-end after firm commitment but before transaction date 4. Disclosure 643 Example 9: cash flow hedge and fair value hedge: disclosure 643 5. Summary 645 621 Chapter 20
  • 3. Gripping IFRS Forward exchange contracts1. Definitions (IAS 32 and IAS 39)The following definitions are provided in IAS 32 and IAS 39:• Fair value: is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.• Firm commitment: is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.• Forecast transaction: is an uncommitted but anticipated future transaction.• Hedging instrument: is a designated derivative or (for a hedge of the risk of changes in foreign currency only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.• Financial instrument: is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Please see the chapter on financial instruments for more information.• Hedged item: is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to risk of changes in fair value or future cash flows and (b) is designated as being hedged.• Hedge effectiveness: is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk, are offset by changes in the fair value or cash flows of the hedging instrument.2. Hedging: an introduction2.1 OverviewYou may be forgiven for thinking that a hedge is simply a row of green bushes planed aroundthe perimeter of a property. You may then also be forgiven for thinking that the hedged itemis the house in the middle of the property and that the hedging instrument is the pair of gardenshears that you use to trim the hedge.As you are hopefully beginning to realise, the world of accounting has many odd and excitingthings (perhaps exciting is not quite the right word?), including hedges, hedged items andhedging instruments. But these obviously do not relate to fuzzy green bushes!In this chapter, we will be focussing on the hedging of foreign currency transactions using themost common method, being the use of a forward exchange contract (FEC).2.2 What is a hedge?So what is a hedge if it is not a green bush?There are various definitions of ‘hedging’ including the following:• ‘to minimise or protect against loss by counterbalancing one transaction, such as a bet, against another’ ( American Heritage® Dictionary of the English Language, Fourth Edition); and• ‘any technique designed to reduce or eliminate financial risk; for example, taking two positions that will offset each other if prices change’ (WordNet ® 2.0, © 2003 Princeton University).When hedging a foreign currency transaction, it means:• taking a position in a financial instrument;• that would counter any change in value of the hedged item;• caused by an exchange rate fluctuation. 622 Chapter 20
  • 4. Gripping IFRS Forward exchange contracts2.3 What is a hedged item? (IAS 39.78 - .84)So what is a hedged item if it is not the house in the middle of the hedged property?The hedged item is an item that is exposed in some way or other (related cash flows or fairvalue) to a risk or many risks (e.g. the risk that the cash outflow will increase if the exchangerate deteriorates - this risk being referred to as a foreign currency risk).A hedged item can be any:• recognised asset or liability, or• unrecognised firm commitment, or• unrecognised highly probable forecast transaction; or a• combination thereof, so long as each hedged item within the group of items have similar risk characteristics. For the purposes of foreign exchange hedging, this means that all the items within the group must be exposed to fluctuations in the same currency.The hedged item could be a single asset or liability, firm commitment or forecast transactionor a group thereof. It could even be part of a portfolio of financial assets or liabilities, wherethe hedge involves interest rate risk only.If the hedged item is a non-financial asset or liability (e.g. inventory), then it can only bedesignated as a hedged item for (a) all risks or (b) foreign currency risks. This is because it isdifficult to prove (by isolating and measuring) that a change in its cash flows or fair value wascaused by a specific risk (e.g. due to a price risk or interest rate risk etc). The only exceptionto this is that it may be possible to attribute a change in cash flow or fair value to foreigncurrency risk.If the hedged item is a financial asset or liability (e.g. loan receivable), then it can bedesignated as a hedged item for specific risks, by isolating and measuring the effect on aportion of the cash flows or on a percentage of its fair value.2.3.1 Forecast transactions (uncommitted future transaction)A forecast transaction is defined as an uncommitted but anticipated future. In other words itis.a transaction that:• has not yet happened; and• has not yet been committed to; but• is expected to happen.One can hedge a transaction:• that has not yet occurred and has not even been committed to (e.g. there is no firm order),• only if it is highly probable to occur (just to ‘expect’ it would not be good enough!).IAS 39 states that highly probable means something that has:• a much greater likelihood of happening than the term more likely than not (IAS 39).The probability of the expected future transaction occurring must be assessed on observablefacts and not just on management’s intentions, because management’s intentions can easilychange. IAS 39IG lists some of the circumstances that should be considered when assessingthe probability of a transaction occurring:• the frequency of similar past transactions; and• the financial and operating ability of the entity to carry out the transaction.2.3.2 Firm commitments (committed future transaction)One can hedge a transaction that:• has not yet happened; but• has been committed to. 623 Chapter 20
  • 5. Gripping IFRS Forward exchange contractsExamples of a firm commitment to a future transaction include:• the entity accepts an order to supply goods to an overseas customer; or• the entity orders goods from a foreign supplier and the order is accepted by that supplier.A firm commitment is defined as a binding agreement for the exchange of a specified quantityof resources at a specified price on a specified future date or dates.Firm commitments are obviously not recognised in the financial statements since thedefinitions and recognition criteria of the elements would not be met. They are thereforeoften referred to as unrecognised firm commitments.Once a firm commitment is made this commitment remains in force until the date of thetransaction. The unrecognised firm commitment exists between order date and the date thatthe risks and rewards transfer (the date the transaction is entered into).A summary of the periods during which a hedge may be in force are as follows: Transaction highly Firm commitment Transaction Transaction probable made happens settledN/A Hedge of a forecast Hedge of a firm Hedge of a N/A transaction commitment transaction Pre-transaction period Post-transaction period2.4 What is a hedging instrument? (IAS 39.72 - .77)So what is a hedging instrument if it is not the pair of garden shears that keeps the hedgearound the house neat, tidy and effective?A hedging instrument is:• is a designated derivative; or• is a designated non-derivative financial asset or non-derivative financial liability (but only when the hedge relates to the risk of changes in foreign currency exchange rates)• whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.There are many possible financial instruments that can be utilised as hedging instruments, forinstance:• a derivative could include options, swaps and futures contracts;• a non-derivative could include a forward exchange contract.An asset or liability denominated in a foreign currency (hedged item) can be hedged by anyfinancial instrument that is expected to gain in value when the hedged item loses value or viceversa. The most common method of hedging foreign exchange denominated transactions isthrough the use of forward exchange contracts (a non-derivative).This chapter’s focus is hedging foreign currency transactions and we will therefore focusexclusively on using forward exchange contracts (FEC’s) as the hedging instrument.2.5 How hedging is achieved using a forward exchange contract A forward exchange contract (FEC) is:• an agreement between two parties;• to exchange a given amount of currency;• for another currency;• at a predetermined exchange rate; and• at a predetermined future date. 624 Chapter 20
  • 6. Gripping IFRS Forward exchange contractsAn entity can therefore ‘lock-in’ at an exchange rate and thereby avoid or minimise losses (ofcourse, possible gains may also be lost or minimised!) on the hedged item that may otherwisehave resulted from fluctuations in the exchange rate.The forward rate agreed upon in the FEC contract will be different to the spot exchange rateavailable on that same date. This is because the forward rate of a FEC approximates theexpected spot rate on the date that the FEC will expire. Thus, the forward rate consists of:• the current spot rate; and• a premium (if the exchange rate is expected to appreciate); or• a discount (if the exchange rate is expected to depreciate).Example 1: FEC to hedge an export transactionHappy Limited, a British company, sold a tractor for $100 000 to Lame Co, a USA company:• The tractor was loaded F.O.B. onto a ship on 1 March 20X5.• Lame Co paid $100 000 to Happy Limited on 31 May 20X5 (due date for repayment).• In order to protect itself against adverse fluctuations in the $: £ exchange rate, Happy Limited entered into a FEC on 1 March 20X5 (expiring on 31 May 20X5). Date Spot rates Forward Rate 1 March 20X5 $1: £0.845 $1: £0.840 31 May 20X5 $1: £0.830 Not requiredRequired:A. Calculate the £ values of Happy Limited’s debtor on 1 March 20X5 and 31 May 20X5.B. Calculate the £ amount actually received by Happy Limited.C. Prepare the journal entries required to record this transaction in Happy Limited’s books for the year ended 30 June 20X5.Solution to example 1: FEC to hedge an export transactionA. 1 March 20X5: Debtor £84 500 ($100 000 x 0.845) 31 May 20X5: Debtor £83 000 ($100 000 x 0.830)B. 31 May 20X5: Received £84 000 ($100 000 x 0.840). At spot exchange rate on the settlement date, Happy Limited would have received £83 000, but because it had entered into an FEC at a forward rate of $1:£0.840, the $100 000 is exchanged into £84 000 ($100 000 x 0.840). Thus, the FEC limited the loss that Happy Limited would have made of £1 500 (£84 500 - £83 000) to a loss of only £500 (£84 500 - £84 000), on its debtor due to exchange rate fluctuations. Note that if the exchange rate had moved in the opposite direction, i.e. if the £ had weakened against the $, the FEC would have prevented Happy Limited from making a gain on its debtor.C. Journals Debit Credit 1 March 20X5 Debtor 84 500 Sales 84 500 Recording sale on transaction date: (100 000 x 0.845) 31 May 20X5 Foreign exchange loss (profit or loss) 1 500 Debtor 1 500 Translating debtor at settlement date: (100 000 x 0.83) – 84 500 625 Chapter 20
  • 7. Gripping IFRS Forward exchange contractsC. 31 May 20X5 continued … Debit Credit FEC asset 1 000 Foreign exchange gain (profit or loss) 1 000 Recognising FEC asset at settlement date: (0.84-0.83) x 100 000 Bank (0.84 x 100 000) 84 000 FEC asset (balance in the account) 1 000 Debtor (balance in the account) 83 000 Expiry of FEC and payment by debtor.2.6 How to discount a forward exchange contractThe value of a FEC asset or liability at any one time will be the difference between:• the forward rate agreed to in the FEC contract; and• the forward rate of an FEC that could be entered into at valuation date, expiring on the same date as the original FEC.As this value will only be payable or receivable in the future it should be discounted to itspresent value, assuming that the effects of present valuing are material.Apart from this next example that shows the effect of present valuing, all other examples willignore present valuing so that you are better able to learn and understand the principles.Example 2: present value of a FECA German entity enters into an FEC on 28 February 20X5 to hedge an import transactionworth ¥1 000 000, due to be settled on 30 November 20X5. The following FECs areavailable at a German bank (in €) on the Japanese Yen (¥): Date Forward Rate to 30 November 20X5 28 February 20X5 €1: ¥140.239 30 June 20X5 €1: ¥135.058 31 August 20X5 €1: ¥146.631An appropriate discount rate is 10%.Required:A. Calculate the value of the FEC in € on; • 30 June 20X5; • 31 August 20X5.B. Show all journals needed to recognise the FEC in the German entity’s books.Solution to example 2A: present value of a FEC30 June 20X5 Rate Amount (¥) Amount payable (€ ) Present values (5 months to expiry)Rate acquired 140.239 1 000 000 7 131 1 000 000/ 140.239 6 853 7 131 / [1.1 ^ (5/12)]Rate now available 135.058 1 000 000 7 404 1 000 000/ 135.058 7 116 7 404 / [1.1 ^ (5/12)] 273 Asset/ gain 263 Asset/ gainThe present value can be calculated using a financial calculator:(1) FV = 7 131 N = 5/12 I = 10 Comp PV: 6 852(2) FV = 7 404 N = 5/12 I = 10 Comp PV: 7 116Explanation: at 30 June 20X5• The German entity took out an FEC on 28 February 20X5 and has thus locked in at an exchange rate of 140.239 and will have to pay 7 131.• Had it waited and taken out the FEC on 30 June 20X5, it would have obtained a rate of 135.058 and had to pay 7 404. 626 Chapter 20
  • 8. Gripping IFRS Forward exchange contracts• By taking out the FEC on 28 February rather than on 30 June 20X5, it saved 273.• There are 5 months to the settlement of the contract and therefore the present value of the gain is based on the present value factor for the next 5 months: 263.31 August 20X5 Rate Amount (¥) Amount payable (€ ) Present values (3 months to expiry)Rate acquired 140.239 1 000 000 7 130 1 000 000/ 140.239 6 963 7 130 / [(1.1 ^ (3/12)]Rate now available 146.631 1 000 000 6 820 1 000 000/ 146.631 6 659 6 820 / [1.1 ^ (3/12)] (310) Liability/ loss (304) Liability/ lossThe present value can be calculated using a financial calculator:(1) FV = 7 130 N = 3/12 I = 10 Comp PV: 6 962(2) FV = 6 820 N = 3/12 I = 10 Comp PV: 6 659Explanation: at 31 August 20X5• The German entity took out an FEC on 28 February 20X5 and has thus locked in at an exchange rate of 140.239 and will have to pay 7 131.• Had it waited and taken out the FEC on 31 August 20X5, it would have obtained a rate of 146.631 and had to pay 6 820.• By taking out the FEC on 28 February rather than on 31 August 20X5, it has to pay an extra 310.• There are now only 3 months to the settlement of the contract and therefore the present value is based on the present value factor for the next 3 months.Solution to example 2B: journals Not Present Valued Present Valued Debit Credit Debit Credit30 June 20X5FEC asset 273 263 Foreign exchange gain (profit or loss) 273 263Recognising FEC asset.31 August 20X5Foreign exchange gain (profit or loss) 274 263 FEC asset 274 263Reversing previous FEC asset and gainForeign exchange loss (profit or loss) 311 304 FEC liability 311 304Re-measuring the FEC on 31 August 20X53. Hedge Accounting3.1 Hedging requirements (IAS 39.88)A hedging relationship between a hedged item and a hedging instrument qualifies for hedgeaccounting only if certain criteria set out in IAS 39 are met. These criteria are:• at the inception of the hedge there is a formal designation and documentation of the hedging relationship and the entity’s risk management objectives and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged (being foreign exchange risk) and how the entity will assess the hedging instrument’s effectiveness in offsetting the exposure in the hedged item’s fair value or cash flows attributable to the hedged risk; 627 Chapter 20
  • 9. Gripping IFRS Forward exchange contracts• the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship;• for cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.• the effectiveness of the hedge can be reliably measured, ie the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured; and• the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.3.2 Hedge effectivenessThe definition of hedge effectiveness requires some elaboration. Remember that whenhedging foreign currency transactions, an entity is trying to protect itself from losses due toexchange rate fluctuations (currency risk). To do so, it uses a hedging instrument, which, forthe purposes of this chapter, is always a FEC. By hedging against currency risks, the entityhopes that any gain or loss on the foreign currency transaction will be exactly offset by anequivalent and opposite gain or loss on the hedging instrument: if, for example, due to achange in exchange rates a foreign creditor requires an extra LC100 to settle, the entity hopesthe FEC will gain in value by LC100.If the hedging instrument perfectly offsets the change in the hedged item, as depicted above,the hedging instrument is said to be 100% effective. It is, however, quite possible that thehedging instrument is not 100% effective: a weakening exchange rate results in a foreigncreditor requiring an extra LC100 to settle, but the FEC only gains in value by LC80. As youcan see, the hedge is no longer 100% effective, but 80% effective (80/ 100). Generally aneffective hedge is a hedge that is 80% - 125% effective. Anything outside of that range willbe an ineffective hedge.3.3 Ineffective hedgesThe ineffective portion of a cash flow hedge is simply recognised in profit or loss (i.e. not inother comprehensive income). Where the hedge is a fair value hedge and is considered to beineffective, the hedge accounting is simply discontinued prospectively. Ineffective hedges arenot discussed in this chapter.3.4 Cash flow hedges versus fair value hedgesThe main difference in accounting for cash flow hedges and fair value hedges is that:• For fair value hedges: gains and losses are immediately recognised in profit or loss;• For cash flow hedges: gains and losses (where the hedge is considered to be an effective hedge) is initially recognised in other comprehensive income and then either: • reclassified to profit or loss (a reclassification adjustment); or • set-off against the carrying amount of the hedged item (a basis adjustment).3.5 Dates relevant to hedging3.5.1 Post-transaction periodJust as in accounting for foreign currency transactions, the hedging relationship must beaccounted for at transaction, translation and settlement dates. These dates obviously happenafter the transaction has been entered into, being a period that we will refer to as the post-transaction period. As mentioned earlier, however, it is also possible to enter into a hedgebefore transaction date. We will refer to the period before transaction date the pre-transaction period. 628 Chapter 20
  • 10. Gripping IFRS Forward exchange contracts3.5.2 Pre-transaction periodThe pre-transaction period can be categorised into two:• an uncommitted; and/ or• a committed period.A FEC may be taken out and designated as a hedge not only before a transaction takes place,but even before we have committed to the transaction. If the future expected transaction isnot certain but it is highly probable that it will take place, it is still possible to use hedgeaccounting. We will call the period between the date on which the transaction becomeshighly probable and the date on which the firm commitment is made (or the date of thetransaction, if no firm commitment is made), the uncommitted period.If an entity firmly commits to a future transaction, the period after making this firmcommitment but before the actual transaction date may be referred to as the committed period.The ‘firm commitment’ date is the date upon which:• the entity accepts an order to supply goods to an overseas customer; or• the entity orders goods from a foreign supplier and the order is accepted by that supplier.It is important to determine whether a firm commitment is made before transaction date andwhether the FEC hedge came into existence:• before the firm commitment (uncommitted period);• between the firm commitment date and transaction date (committed period); and/ or• after transaction datebecause a hedge during each of these different periods may be accounted for differently.3.5.3 Summary of periods and descriptionsA summary of the different dates is as follows:Transaction highly probable Firm commitment made Transaction happens Transaction settledN/A Hedge of a forecast transaction Hedge of a firm commitment Hedge of a transaction N/A Pre-transaction period Post-transaction period3.6 Types of hedges (IAS 39.85 - .102)3.6.1 OverviewThere are three types of hedges:• fair value hedges;• cash flow hedges; and• hedge of a net investment in a foreign operation.A hedge of a net investment in a foreign operation is not discussed in this chapter.3.6.2 Fair value hedges (IAS 39.89 - .94)A fair value hedge is defined as:• a hedge of the exposure to changes in fair value:• of a recognised asset or liability; or• of an unrecognised firm commitment; or• of an identified portion thereof• that is attributable to a particular risk and• that could affect profit. 629 Chapter 20
  • 11. Gripping IFRS Forward exchange contractsAll changes to the fair value are recognised in profit or loss (part of the statement ofcomprehensive income).In terms of foreign currency risks, a fair value hedge, hedges:• a recognised asset or liability; or• an unrecognised firm commitment• against changes in its fair value• that may result from fluctuations in exchange rates.As an example of a fair value hedge, imagine an investment that is denominated in a foreigncurrency: if between transaction and settlement dates, the local currency strengthens againstthe foreign currency, the fair value of the investment in the entity’s local (functional) currencywill decrease. For example, an entity owns an investment with a fair value of FC100 000. Atthe end of the last financial year, it would take LC5 to buy FC1. It now only takes LC4 tobuy FC1. The fair value of the investment has therefore dropped from LC500 000 toLC400 000. A fair value hedge would attempt to neutralise any such decrease in fair value.3.6.3 Cash flow hedges (IAS 39.95 - .101)A cash flow hedge is defined as:• a hedge of the exposure to changes in cash flows:• of a recognised asset or liability; or• of a highly probable forecast transaction;• that is attributable to a particular risk; and• that could affect profit.Also note that although not specifically mentioned in the definition of a cash flow hedgeprovided in IAS 39.86(b), a hedge can be designated a cash flow hedge if it relates to:• a firm commitment, so long as the hedging instrument (FEC) hedges against foreign currency risks.Therefore, in terms of foreign currency risks, a cash flow hedge, hedges:• a recognised asset or liability; or• a highly probable forecast transaction; or• a firm commitment; (applies only to the hedge of currency risk!)• against any associated variability in cash flows attributable to exchange rate fluctuations.For example, imagine a foreign creditor: if between transaction and settlement date the localcurrency weakens against the foreign currency, the amount payable will increase. Forexample, an entity owes a foreign creditor FC100 000. If at transaction date, it would takeLC5 to buy FC1 and now it takes LC6 to buy FC1, the settlement of the foreign creditorwould now require a cash outflow of LC600 000 instead of only LC500 000. A cash flowhedge would attempts to neutralise such an increase in the potential cash outflow arising fromexchange rate fluctuations.3.6.4 Summary of the hedges over the periodsIt should be clear from the above that how a FEC is accounted for (i.e. as a cash flow hedgeor a fair value hedge) depends largely on whether we are looking at its existence during:• an uncommitted pre-transaction period (before a firm commitment is made and before transaction date);• a committed pre-transaction period (after a firm commitment is made but before transaction date);• the post-transaction period (between the transaction date and settlement date). 630 Chapter 20
  • 12. Gripping IFRS Forward exchange contractsThe following timeline summarises all the possible hedging treatments: Transaction date Pre-transaction period Post-transaction period No firm commitment: Fair value hedge* OR Cash flow hedge Cash flow hedge Firm commitment: Before firm After firm commitment: commitment: (committed period) * this chapter will treat all hedges during this (uncommitted period) period as fair value hedges Cash flow hedge Cash flow hedge or Fair value hedgeExplanation of the above summary timeline:• If the FEC exists before the transaction date and before a firm commitment is entered into, the movement in the FEC rates up to the date that the firm commitment is made (or up to the transaction date, if no firm commitment is made at all) is always treated as a cash flow hedge.• In all other periods of the FEC’s existence, the FEC may be treated as either a cash flow hedge or a fair value hedge.• Although IAS 39 allows a hedge after transaction date to be treated either as a cash flow hedge or a fair value hedge, this chapter, for the sake of simplicity, shall treat all hedges in the post-transaction period as fair value hedges.3.7 Accounting for hedgesIt is important to always separate in your mind:• the basic foreign currency transaction (being the hedged item); and• the FEC entered into (being the hedging instrument).The foreign currency transaction is initially accounted for at the spot rate and then translatedat year-end and settlement dates. The foreign exchange gains or losses are recogniseddirectly in profit or loss. This is covered in the chapter on foreign currency transactions.The forward exchange contract is accounted for either as a:• cash flow hedge; or• fair value hedge.The hedge is measured at firm commitment date, year-end, transaction and settlement dates(whichever applies) and the gain or loss on the FEC is recognised:• for fair value hedges: recognised directly in profit or loss; or• for cash flow hedges: recognised in other comprehensive income (this equity account could have either a debit or credit balance!) and then either: - using a basis adjustment: the gain or loss in equity is set-off against the carrying amount of the hedged item (e.g. imported inventory) on transaction date. ; or - using a reclassification adjustment: the gain or loss in equity is reclassified to profit or loss when the hedged item affects profit or loss (e.g. reverse the other comprehensive income (or a portion thereof) to profit or loss as and when the inventory is sold (or a portion thereof is sold)).The basis adjustment is only allowed if the hedged forecast transaction is going to result innon-financial assets or liabilities. Reclassification adjustments are allowed whether thehedged forecast transaction results in assets or liabilities that are financial or non-financial.Both the basis adjustments and the reclassification adjustments have the same effect on profitover a period of time. When the basis adjustment is used, other comprehensive income(equity) is eventually recognised in profit or loss but only when the hedged item affects profitor loss (therefore other comprehensive income reaches profit or loss indirectly). 631 Chapter 20
  • 13. Gripping IFRS Forward exchange contractsFor example: imagine that a gain is recognised as other comprehensive income and that thisgain is subsequently credited to inventory via a basis adjustment (debit OCI equity and creditinventory): the future cost of sales will be decreased. Thus, the gain will be recognised inprofit or loss as and when the inventory (reduced by the basis adjustment) is expensed as costof sales.3.8 FEC’s in the period post-transaction dateTransaction date Settlement date Post-transaction periodIf the FEC exists in the post-transaction period (i.e. on or after the transaction date) it canbe treated as either:• a fair value hedge; or• a cash flow hedge.Whether the FEC after transaction date is treated as a fair value hedge or a cash flow hedgehas no effect on the profit or loss over a period of time,. Therefore, for the sake of simplicity,we will assume that an FEC that is in existence after transaction date is always treated as afair value hedge.The dates that are important during this period obviously include:• transaction date• settlement date• reporting date (normally a financial year-end): a financial year-end may not necessarily occur between transaction and settlement date, but it is equally possible that there may even be more than one reporting date between these two dates.Example 3: FEC taken out in the post-transaction period: fair value hedgeInventory is purchased for $100 000.A FEC is taken out on transaction date at the FEC rate of C9: $1 (set to expire on payment date).At 30 June 20X1 (year end), the rate available on similar FEC’s expiring on this same paymentdate is C9,60: $1.100% of this inventory was sold on 15 July 20X1 for C1 000 000. Fair value hedge 1 March 20X1 30 June 20X1 7 July 20X1 Dates: Transaction date Year-end Payment date and FEC date FEC rates: 9.00 9.60 N/A Spot rate: 8.50 8.90 10Required:Show all related journal entries assuming that this FEC has been designated as a fair valuehedge. .Solution to example 3: FEC in the post-transaction period as a fair value hedgeQuick explanation: by entering into the FEC, we know that we will have to pay $100 000 x 9 =C900 000 since this is the rate we committed to in the FEC.If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we wouldhave had to pay $100 000 x 10 = C1 000 000.The FEC has therefore saved us C1 000 000 – C900 000 = C100 000.This gain is recognised over the life of the FEC (60 000 at year-end and another 40 000 on paymentdate). 632 Chapter 20
  • 14. Gripping IFRS Forward exchange contracts1 March 20X1: transaction date Debit CreditInventory 100 000 x 8.50 (spot rate on 850 000 Foreign creditor transaction date) 850 000Inventory purchased, measured at spot rate on transaction dateNo entries relating to the FEC are processed30 June 20X1: year-endForex loss (profit or loss) 100 000 x 8.90: spot rate at year-end – 40 000 Foreign creditor 100 000 x 8.50 previous spot rate 40 000Foreign creditor translated to spot rate at year-endFEC asset 100 000 x 9.60 FEC rate at year-end – 60 000 Forex gain (profit or loss) 100 000 x 9 FEC rate obtained 60 000Gain or loss on FEC recognised at year-end7 July 20X1: payment dateForex loss (profit or loss) 100 000 x 10: spot rate at payment date 110 000 Foreign creditor – 100 000 x 8.90 previous spot rate 110 000Foreign creditor translated on payment dateFEC asset 100 000 x 10 spot rate on payment date – 40 000 Forex gain (profit or loss) 100 000 x 9.60 prior FEC rate (30/6/X1) 40 000Gain or loss on FEC recognised on payment dateForeign creditor (850 000 + 40 000 + 110 000) 1 000 000 FEC asset (60 000 + 40 000) 100 000 Bank (100 000 x 9) 900 000Payment of foreign creditor at FEC rate: the rate we agreed to in thecontract15 July 20X1: on sale of inventoryCost of sales 850 000 Inventory 850 000Debtor 1 000 000 Sales 1 000 000100% of inventory sold: 850 000 x 100%Note: ‘Forex’ is short for ‘foreign exchange’3.9 FEC’s in the period pre-transaction dateIf an FEC is entered into prior to transaction date, the pre-transaction date will be the periodfrom when the FEC was entered into up to transaction date.FEC date Transaction date Pre-transaction periodPlease note: the FEC date (on the above timeline) refers to the date on which the FEC isentered into.If the FEC exists in the pre-transaction period (i.e. before the transaction date) it can betreated as either:• a fair value hedge; or• a cash flow hedge.Whether the FEC is to be accounted for as a fair value or cash flow hedge is largelydetermined whether or not a firm commitment was in existence. 633 Chapter 20
  • 15. Gripping IFRS Forward exchange contractsIf the FEC exists in the pre-transaction period, one must therefore also ascertain whether afirm commitment was made before transaction date or not. If a firm commitment was made,we will also need to plot the date that we made this firm commitment onto our timeline.3.9.1 If there is no firm commitmentFEC date Transaction date Pre-transaction period (uncommitted): always a cash flow hedgeIf no firm commitment is made, a FEC existing before transaction date is hedging anuncommitted but highly probable future transaction (also referred to as a hedged forecasttransaction) and is always treated as a cash flow hedge. In this case:• any gains or losses on the FEC up to transaction date are first recognised as other comprehensive income; and• on transaction date, the other comprehensive income is used to adjust the related asset or liability (basis adjustment) or reclassify it to profit or loss when the related asset or liability affects profit or loss (a reclassification adjustment).Any changes in the FEC rate after transaction date are either:• taken directly to profit or loss, as explained above (i.e. as a fair value hedge) or are• first recognised as other comprehensive income and then reversed to profit or loss (i.e. as a cash flow hedge).Once again, for the sake of simplicity, we will always treat a FEC that is in existence duringthis transaction period as a fair value hedge. Example 4: FEC taken out in the pre-transaction period (no firm commitment): cash flow hedge (with a basis adjustment)Inventory is purchased for $100 000. A FEC was taken out before transaction date.• No firm commitment was made before transaction date.• The FEC rate obtained was C9: $1. This FEC will expire on payment date.• FEC rates available on the relevant dates, on similar FEC’s that would expire on this same payment date, are shown below.• 40% of the inventory was sold on 15 July 20X1 for C400 000 and 60% of the inventory was sold on 20 August 20X1 for C600 00. Cash flow hedge Fair value hedge 15 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1Dates: FEC date Transaction date Year-end Payment dateFEC rates: 9.00 9.10 9.60 N/ASpot rate: N/A 8.50 8.90 10Required:Show all related journal entries assuming that this FEC is accounted for as a cash flow hedgeto transaction date and as a fair value hedge thereafter.Any other comprehensive income created is reversed using the basis adjustment approach.Solution to example 4: FEC in the pre-transaction period (no firm commitment): cashflow hedge (with a basis adjustment)As with the previous example, we know that we will have to pay $100 000 x 9 = C900 000 since this isthe rate we have committed to in the FEC.If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we wouldhave had to pay $100 000 x 10 = C1 000 000.The FEC has therefore saved us C1 000 000 – C900 000 = C100 000. 634 Chapter 20
  • 16. Gripping IFRS Forward exchange contracts Debit Credit15 February 20X1: FEC entered intoNo entries relating to the FEC are processed1 March 20X1: transaction dateInventory 100 000 x 8.50 (spot rate on transaction 850 000 Foreign creditor date) 850 000Inventory purchased at spot rate on transaction dateFEC asset 100 000 x 9.10 FEC rate on transaction 10 000 FEC equity (OCI) date – 100 000 x 9 FEC rate obtained 10 000Cash flow hedge: gain/ loss recognised on transaction date as OCIFEC equity (OCI) 10 000 Inventory 10 000Basis adjustment of the cash flow hedge: OCI set-off against the hedgeditem on transaction date30 June 20X1: year-endFEC asset 100 000 x 9.60 FEC rate at year end – 50 000 Forex gain (profit or loss) 100 000 x 9.10 previous FEC rate 50 000Gain or loss on FEC recognised at year-endForex loss (profit or loss) 100 000 x 8.90: spot rate at year-end – 40 000 Foreign creditor 100 000 x 8.50 previous spot rate 40 000Foreign creditor translated to spot rate at year-end7 July 20X1: payment dateFEC asset 100 000 x 10 spot rate on payment date – 40 000 Forex gain (profit or loss) 100 000 x 9.60 previous FEC rate 40 000Gain or loss on FEC recognised on payment dateForex loss (profit or loss) 100 000 x 10: spot rate at year end – 110 000 Foreign creditor 100 000 x 8.90 previous spot rate 110 000Foreign creditor translated to spot rate on payment dateForeign creditor (850 000 + 40 000 + 110 000) 1 000 000 FEC asset (10 000 + 50 000 + 40 000) 100 000 Bank (100 000 x 9) 900 000Payment of foreign creditor at FEC rate: (C9: $1)15 July 20X1: on sale of inventoryCost of sales (850 000 – 10 000) x 40% 336 000 Inventory 336 000Debtor Given 400 000 Sales 400 00040% of inventory sold: sales and cost of sales20 August 20X1: on sale of inventoryCost of sales (850 000 – 10 000) x 60% 504 000 Inventory 504 000Debtor Given 600 000 Sales 600 00060% of inventory sold: sales and cost of sales*** The basis adjustment decreases the cost of inventory. This then decreases cost of sales as the inventory is sold. The gain is thus indirectly taken to profit or loss as and when the hedged item affects profit/ loss. 635 Chapter 20
  • 17. Gripping IFRS Forward exchange contractsExample 5: FEC taken out in the pre-transaction period (no firm commitment): cashflow hedge (with a reclassification adjustment)Required:Repeat the previous example assuming that the entity used a reclassification adjustment for itsother comprehensive income.Solution to example 5: FEC in the pre-transaction period (no firm commitment): a cashflow hedge (with reclassification adjustments)Comment:This example is the same as example 4 except that the other comprehensive income is reclassified.The journal that reversed equity to inventory on transaction date in example 4 therefore does nothappen in example 5 when using a reclassification adjustment.The other differences have been highlighted in the following journals with asterisks so that you arebetter able to compare the journals of example 5 (reclassification adjustment) with those of example 4(basis adjustment).15 February 20X1: FEC entered into Debit CreditNo entries relating to the FEC are processed1 March 20X1: transaction dateInventory 100 000 x 8.50 (spot rate on transaction 850 000 Foreign creditor date) 850 000Inventory purchased recognised at spot rate on transaction dateFEC asset 100 000 x 9.10 FEC rate on transaction date 10 000 FEC equity (OCI) – 100 000 x 9 FEC rate obtained 10 000Cash flow hedge: gain/ loss recognised on transaction date is OCI30 June 20X1: year-endFEC asset 100 000 x 9.60 FEC rate at year-end – 50 000 Forex gain (profit or loss) 100 000 x 9.10 previous FEC rate 50 000Gain or loss on FEC recognised at year-endForex loss (profit or loss) 100 000 x 8.90: spot rate at year-end – 40 000 Foreign creditor 100 000 x 8.50 previous spot rate 40 000Foreign creditor translated to spot rate at year-end:7 July 20X1: payment dateFEC asset 100 000 x 10 spot rate on payment date – 40 000 Forex gain (profit or loss) 100 000 x 9.60 previous FEC rate 40 000Gain or loss on FEC recognised on payment date to profit & lossForex loss (profit or loss) 100 000 x 10: spot rate at payment date 110 000 Foreign creditor – 100 000 x 8.90 previous spot rate 110 000Foreign creditor translated to spot rate on payment dateForeign creditor (850 000 + 40 000 + 110 000) 1 000 000 FEC asset (10 000 + 50 000 + 40 000) 100 000 Bank (100 000 x 9) 900 000Payment of foreign creditor at FEC rate: C9: $1 636 Chapter 20
  • 18. Gripping IFRS Forward exchange contracts15 July 20X1: on sale of inventory Debit CreditCost of sales *** 850 000 x 40% 340 000 Inventory *** 340 000Debtor Given 400 000 Sales 400 00040% of inventory sold: sales and cost of sales recognisedFEC equity (OCI) *** 10 000 x 40% 4 000 Forex gain *** 4 000Reclassification adjustment of the cash flow hedge: reclassifying 40% ofthe OCI to profit or loss when 40% of the inventory is sold20 August 20X1: on sale of inventoryCost of sales *** 850 000 x 60% 510 000 Inventory *** 510 000Debtor Given 600 000 Sales 600 00060% of inventory sold: sales and cost of sales recognisedFEC equity (OCI) *** 10 000 x 60% 6 000 Forex gain *** 6 000Reclassification adjustment of the cash flow hedge: reclassifying 60% ofthe OCI to profit or loss when 40% of the inventory is soldBy the way, if the entity had purchased an item of property, plant and equipment (instead of an item ofinventory) and had chosen to use a reclassification adjustment, then the FEC equity (OCI) would berecognised as a gain (or as a loss, as the case may be) over the useful life of the asset (i.e. as the assetis depreciated). Compare this to where a gain is recognised as inventory is sold.3.9.2 If there is a firm commitmentFEC date Firm commitment Transaction date Pre-transaction period Uncommitted Committed Always a cash flow hedge Cash flow hedge/ Fair value hedgeIf the FEC exists before transaction date and before a firm commitment (e.g. a firm order) isentered into, the pre-transaction period is split into:• before firm commitment is made (if applicable): the uncommitted period; and• after the firm commitment is made (but before the transaction date): the committed period.The FEC during an uncommitted period is always treated:• as a cash flow hedge, (there is no option here): for treatment of a cash flow hedge, see previous discussion (3.9.1) and example 4 and 5.The FEC during the committed period (after a firm commitment is made but beforetransaction date) may be treated either:• as a cash flow hedge:; or• as a fair value hedge.The FEC in a committed period may only be treated as a cash flow hedge if it is specifically ahedge against the foreign currency risk. 637 Chapter 20
  • 19. Gripping IFRS Forward exchange contractsIf your entity treats the movement in the FEC rates during the committed period as a cashflow hedge then read the previous discussion (3.9.1) and example 4 and 5.If the entity chooses to record the movement in the FEC rates during the committed period asa fair value hedge, then the effect of the movement in both the spot rate and the FEC ratesmust be recorded as follows:• firm commitment asset/ liability: measured using: the movement in the spot rates journalised as: Firm commitment asset/ liability (dr/ cr) and Profit or loss (cr/ dr) reversed when: the firm commitment asset or liability will then be reversed on transaction date to the related transaction;• forward exchange contract asset/ liability: measured using: the movement in the FEC rates journalised as: FEC asset/ liability (dr/ cr) and Profit or loss (cr/dr) reversed when: the FEC asset will then be reversed on settlement date when paying the creditor or receiving cash from the debtor.Example 6: FEC taken out in the pre-transaction period with a firm commitment: cashflow hedge up to transaction dateInventory is purchased for $100 000. A FEC is taken out before transaction date. After theFEC was taken out, a firm commitment was made.• The FEC rate obtained was C9: $1. This FEC will expire on payment date.• FEC rates available on the relevant dates, on similar FEC’s that would expire on the same payment date, are shown below. 40% of the inventory was sold on 15 July 20X1 for C400 000 and 60% of the inventory was sold on 20 August 20X1 for C600 000. Cash flow hedge Fair value hedge 15 Feb 20X1 22 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1 FEC taken out Firm commitment Transaction date Year-end Payment dateFEC rates: 9.00 9.06 9.10 9.60 N/ASpot rates: N/A 8.30 8.50 8.90 10.00Required:Show all related journal entries assuming that FEC is to be treated as a cash flow hedge forthe entire period before transaction date whereas after transaction date, the FEC is to betreated as a fair value hedge.Solution to example 6: firm commitment to transaction date as a cash flow hedge1 March 20X1: transaction date Debit CreditForex loss (profit or loss) 100 000 x 8.50 spot rate on transaction date 20 000 Firm commitment liability – 100 000 x 8.30 on firm commitment date 20 000Gain or loss on firm commitment recognised on transaction date:Firm commitment liability 20 000 Inventory 20 000Firm commitment reversed to the hedged item on transaction date(similar to a basis adjustment)If the entity reverses other comprehensive income using a:• basis adjustment, the journals will be the same as those under example 4;• reclassification adjustment, the journals will be the same as those under example 5. 638 Chapter 20
  • 20. Gripping IFRS Forward exchange contractsExample 7 FEC taken out in the pre-transaction period: cash flow hedge up to firmcommitment date and then a fair value hedge up to transaction dateRequired:Repeat example 6 assuming that the FEC• before firm commitment date is a cash flow hedge, where any other comprehensive income is reversed using a basis adjustment• is treated as a fair value hedge after the firm commitment date up to the transaction date; and• is still treated as a fair value hedge after transaction date.Solution to example 7: firm commitment to transaction date as a fair value hedgePlease remember that when a FEC exists before the firm commitment, there is no choice: it is alwaystreated as a cash flow hedge.As with the previous examples, the FEC has saved us C1 000 000 – C900 000 = C100 000.This gain is recognised as the hedged item affects profit or loss (the cash flow hedge: 6 000 as theinventory is sold; and the fair value hedges: 4 000 on transaction date, 50 000 at year-end and 40 000on payment date):15 February 20X1: date FEC entered into Debit CreditNo entries relating to the FEC are processed22 February 20X1: firm commitment dateFEC asset 100 000 x 9.06 FEC rate on firm commit 6 000 FEC equity (OCI) date – 100 000 x 9 FEC rate obtained) 6 000Gain or loss on FEC recognised on firm commitment date1 March 20X1: transaction dateInventory 100 000 x 8.50 (spot rate on transaction 850 000 Foreign creditor date) 850 000Inventory purchased, measured at spot rate on transaction dateFEC equity (OCI) 6 000 Inventory 6 000Cash flow hedge – basis adjustment: reclassifying OCI to the hedgeditem on transaction dateFEC asset 100 000 x 9.10 FEC rate on transaction 4 000 Forex gain (profit or loss) date – 100 000 x 9.06 previous FEC rate 4 000Gain or loss on FEC recognised on transaction date:Forex loss (profit or loss) 20 000 Firm commitment liability 20 000Gain or loss on firm commitment recognised on transaction date:100 000 x 8.50 spot rate on transaction date – 100 000 x 8.30 spot rateon firm commitment dateFirm commitment liability 20 000 Inventory 20 000Firm commitment reversed to the hedged item on transaction date(similar to a basis adjustment)30 June 20X1: year-endFEC asset 100 000 x 9.60 FEC rate at year-end – 50 000 Forex gain (profit or loss) 100 000 x 9.10 previous FEC rate 50 000Gain or loss on FEC recognised at year-end: 639 Chapter 20
  • 21. Gripping IFRS Forward exchange contracts30 June 20X1: year-end continued … Debit CreditForex loss (profit or loss) 100 000 x 8.90: spot rate at year-end – 40 000 Foreign creditor 100 000 x 8.50 previous spot rate 40 000Foreign creditor translated to spot rate at year-end7 July 20X1: payment dateFEC asset 100 000 x 10 spot rate on payment date – 40 000 Forex gain (profit or loss) 100 000 x 9.60 previous FEC rate 40 000Gain or loss on FEC recognised on payment dateForex loss (profit or loss) 100 000 x 10: spot rate on payment date 110 000 Foreign creditor – 100 000 x 8.90 previous spot rate 110 000Foreign creditor translated on payment dateForeign creditor (850 000 + 40 000 + 110 000) 1 000 000 FEC asset (6 000 + 4 000 + 50 000 + 40 000) 100 000 Bank (100 000 x 9) 900 000Payment of foreign creditor at FEC rate obtained: C9: $115 July 20X1: date of sale of inventoryCost of sales (850 000 – 6 000 – 20 000) x 40% 329 600 Inventory 329 600Debtor Given 400 000 Sales 400 00040% of inventory sold: sales and cost of goods sold20 August 20X1: date of sale of inventoryCost of sales (850 000 – 6 000 – 20 000) x 60% 494 400 Inventory 494 400Debtor Given 600 000 Sales 600 00060% of inventory sold: sales and cost of goods soldNotice that when using this basis adjustment approach to reversing other comprehensive income, theinventory is measured as follows: Inventory recognised at spot rate on transaction date 100 000 x 8.50 850 000 FEC equity (OCI) reversed to inventory on transaction date (the cash flow (6 000) hedge) Firm commitment liability reversed to inventory on transaction date (20 000) 824 000Had we used the reclassification approach instead, the other comprehensive income would have beenreclassified directly to profit or loss and would not have affected the inventory balance. The resultwould then have been that inventory would have been measured at the spot rate on the date that thefirm commitment was made: Inventory recognised at spot rate on transaction date 100 000 x 8.50 850 000 Firm commitment liability reversed to inventory on transaction date (20 000) 100 000 x 8.30 830 000 640 Chapter 20
  • 22. Gripping IFRS Forward exchange contractsExample 8: FEC taken out in the pre-transaction period with a year-end after firmcommitment but before transaction dateInventory is purchased for $100 000. A FEC is taken out before transaction date and before afirm commitment was made:• The FEC rate obtained was C9: $1. This FEC will expire on payment date.• FEC rates available on similar FEC’s expiring on payment date, are shown below.• 40% of the inventory purchased was sold on 27 September 20X1.• 60% of the inventory purchased was sold on 1 November 20X1. Cash flow hedge Fair value hedge Fair value hedge 1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 August 20X1 FEC taken out Firm commitment Year-end Transaction date Payment dateFEC rates: 9.00 9.06 9.10 9.60 N/ASpot rates: 8.10 8.30 8.45 8.50 10.00Required:A. Assume that the period between the firm commitment date and the transaction date is to be recognised as a fair value hedge and that after transaction date, the hedge is also to be treated as a fair value hedge. Where the FEC is treated as a cash flow hedge, the entity uses the basis adjustment to reclassify other comprehensive income.B. Show how the journals would change if the reclassification approach was used instead.Solution to example 8A: FEC in the pre-transaction period with a firm commitment1 March 20X1: date FEC entered into Debit CreditNo entries relating to the FEC are processed15 April 20X1: firm commitment dateFEC asset 100 000 x 9.06 FEC rate on transaction 6 000 FEC equity (OCI) date – 100 000 x 9 FEC rate obtained 6 000Gain or loss on FEC recognised on firm commitment date30 June 20X1: year-endFEC asset 100 000 x 9.10 FEC rate at year-end – 4 000 Forex gain 100 000 x 9.06 previous FEC rate 4 000Gain or loss on FEC recognised at year-endForex loss 100 000 x 8.45 spot rate at yr-end – 100 000 x 15 000 Firm commitment liability 8.30 spot rate on firm commitment date 15 000Gain or loss on firm commitment recognised at year-end20 July 20X1: transaction dateInventory 100 000 x 8.50 spot rate on transaction 850 000 Foreign creditor date 850 000Inventory purchased, measured at spot rate on transaction dateFEC asset 100 000 x 9.60 FEC rate on transaction 50 000 Forex gain date – 100 000 x 9.10 previous FEC rate 50 000Gain or loss on FEC recognised on transaction dateForex loss 100 000 x 8.50 spot rate on trans date – 5 000 Firm commitment liability 100 000 x8.45 prior spot rate 5 000Gain or loss on firm commitment recognised on transaction dateFirm commitment liability (15 000 + 5 000) 20 000 Inventory 20 000Firm commitment reversed to inventory on transaction date 641 Chapter 20
  • 23. Gripping IFRS Forward exchange contracts20 July 20X1: transaction date continued … Debit CreditFEC equity (OCI) 6 000 Inventory 6 000Cash flow hedge – basis adjustment: reclassifying OCI against thehedged item on transaction date (this journal would not be posted ifthe reclassification approach was used instead)31 August 20X1: payment dateFEC asset 100 000 x 10 spot rate on payment date – 40 000 Forex gain 100 000 x 9.60 previous FEC rate 40 000Gain or loss on FEC recognised on payment dateForex loss 100 000 x 10 spot rate on payment date – 150 000 Foreign creditor 100 000 x 8.50 previous spot rate 150 000Foreign creditor translated to spot rate on payment dateForeign creditor (850 000 + 150 000) 1 000 000 FEC asset (6 000 + 4 000 + 50 000 + 40 000) 100 000 Bank (100 000 x 9 FEC rate obtained) 900 000Foreign creditor paid at FEC rate obtained:27 September 20X1: sale of 40% of the inventoryCost of sales (850 000 – 20 000 – 6 000) x 40% 329 600 Inventory 329 60040% of inventory sold1 November 20X1: sale of 60% of the inventoryCost of sales (850 000 – 20 000 – 6 000) x 60% 494 400 Inventory 494 40060% of inventory soldSolution to example 8B: FEC in the pre-transaction period with a firm commitmentIf the reclassification adjustment is used, the following entry will be posted on 27 September 20X1instead of the basis adjustment entry posted on 20 July 20X1 (notice that the cost of sales entry is alsodifferent because the inventory balance has not been reduced by the C6 000 basis adjustment):27 September 20X1: sale of 40% of the inventory Debit Credit FEC equity (OCI) 6 000 x 40% 2 400 Forex gain 2 400 Cash flow hedge – reclassification adjustment: reclassifying 40% of the OCI to profit or loss when 40% of the inventory is sold Cost of sales (850 000 – 20 000) x 40% 332 000 Inventory 332 000 40% of inventory sold1 November 20X1: sale of 60% of the inventory FEC equity (OCI) 6 000 x 60% 3 600 Forex gain 3 600 Cash flow hedge – reclassification adjustment: reclassifying 60% of the OCI to profit or loss when 60% of the inventory is sold Cost of sales (850 000 – 20 000) x 60% 498 000 Inventory 498 000 60% of inventory sold 642 Chapter 20
  • 24. Gripping IFRS Forward exchange contracts4. Disclosure (IAS 32)Disclosure requirements for hedges are set out in IAS 32.An entity shall describe its financial risk management objectives and policies including itspolicy for hedging each main type of forecast transaction that is accounted for as a hedge.An entity shall disclose the following for designated fair value and cash flow hedges:• a description of the hedge;• a description of the financial instruments designated as hedging instruments and their fair values at the end of the reporting period;• the nature of the risks being hedged; and• for cash flow hedges: the periods in which the cash flows are expected to occur, when they are expected to affect profit or loss and a description of any forecast transaction for which hedge accounting had been used but which is no longer expected to occur.When a gain or loss on a hedging instrument in a cash flow hedge has been recognised inother comprehensive income, an entity shall disclose the amount that was:• recognised in other comprehensive income during the period;• reclassified from equity and included in profit or loss for the period (reclassification adjustment); and• removed from other comprehensive income during the period and included in the initial measurement of the acquisition cost or carrying amount of a non-financial asset or non- financial liability (basis adjustment).Example 9: cash flow hedge and fair value hedge: disclosureUse the same information as in the previous example 8A, where an inventory purchase of$100 000 is hedged by an FEC. The details are repeated here for your convenience: Cash flow hedge Fair value hedge Fair value hedge 1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 August 20X1 FEC taken out Firm commitment Year-end Transaction date Payment dateFEC rates: 9.00 9.06 9.10 9.60 N/ASpot rates: 8.10 8.30 8.45 8.50 10.00 20X2 20X1 Revenue 12 000 000 10 000 000 Cost of sales 5 000 000 3 000 000Required:Disclose all information possible in the financial statements for the year ended 30 June 20X2(assuming, once again, that the period up to firm commitment date is a cash flow hedge andthat, thereafter, the hedge is designated as a fair value hedge).The basis adjustment is used for any cash flow hedge recognised in other comprehensiveincome. You may assume that all the necessary journals have been processed correctly.Ignore tax. 643 Chapter 20
  • 25. Gripping IFRS Forward exchange contractsSolution to example 9: cash flow hedge and fair value hedge: disclosureApple LimitedStatement of compr ehensive incomeFor the year ended 30 J une 20X2 Notes 20X2 20X1 C CRevenue 12 000 000 10 000 000Cost of sales (5 000 000) (3 000 000)Other income 90 000 4 000Other expenses (155 000) (15 000)Profit before tax 10 6 935 000 6 989 000Tax expense (ignored) 0 0Profit for the year 6 935 000 6 989 000Other comprehensive income, net of tax 11Cash flow hedges (6 000) 6 000Total comprehensive income 6 929 000 6 995 000Apple LimitedStatement of changes in equity (extr acts)For the year ended 30 J une 20X2 Retained Cash flow Total earnings hedges C C CBalance 1/7/20X0 xxx 0 xxxTotal comprehensive income 6 989 000 6 000 6 995 000Balance 1/7/20X1 xxx 6 000 xxxTotal comprehensive income 6 935 000 (6 000) 6 929 000Balance 30/6/20X1 xxx 0 xxxApple LimitedNotes to the financial statements (extr acts)For the year ended 30 J une 20X2 20X2 20X1 C C10. Profit before taxProfit before tax is stated after taking into account the following separately disclosable (income)/expense itemsForeign exchange gain 20X2: 50 000 (2) + 40 000 (3) (90 000) (4 000) (1)Foreign exchange loss 20X2: 5 000 (5) + 150 000 (6) 155 000 15 000 (4)11. Other comprehensive incomeGain arising during the year on movement in cash flow hedge 6 000Basis adjustment (adjustment for amounts transferred to the (6 000)initial carrying amounts of the hedged items)(1) (9.10 – 9.06) x $100 000 = R4 000 (gain on FEC FV hedge at year-end)(2) (9.60 – 9.10) x $100 000 = R50 000 (gain on FEC FV hedge on transaction date)(3) (10.00 – 9.60) x $100 000 = R40 000 (gain on FEC FV hedge on payment date)(4) (8.45 – 8.30) x $100 000 = R15 000 (loss on translation of firm commitment at year-end)(5) (8.50 – 8.45) x $100 000 = R5 000 (loss on translation of firm commitment on transaction date)(6) (10.00 – 8.50) x $100 000 = R150 000 (loss on translation of creditor on payment date) 644 Chapter 20
  • 26. Gripping IFRS Forward exchange contracts 5. Summary Forward exchange contracts Pre-transaction period Post-transaction period Depends on whether there was a Cash flow hedge or firm commitment made before Fair value hedge transaction date Firm commitment made before Firm commitment not made before transaction date transaction date Depends on whether the FEC was Cash flow hedge entered into during: Uncommitted period Committed period Before the firm commitment is made On/ after firm commitment made Cash flow hedge Cash flow/ Fair value hedge (i.e. from date FEC entered into up (i.e. after firm commitment date to to the date the firm commitment is transaction date) made) Equity created when using cash flow hedge Recognise as profit or loss using a: Reclassification adjustment Basis adjustment Reclassify other comprehensive Reverse other comprehensive income income to profit or loss (i.e. directly) to the hedged item e.g. a non-financial when the hedged item affects profit asset/ liability or loss (e.g. when inventory is sold) The OCI equity will then reach profit or loss (indirectly) when the hedged This is called a item affects profit or loss reclassification adjustment (e.g. when inventory is sold) The basis adjustment may not be used if the related asset is a financial asset/ liability 645 Chapter 20